Beyond Bulls & Bears

Fixed Income

An overview of US state budgets and municipal bonds

As COVID-era funding boosts come to a close, US state and local governments are facing some challenges. However, they have many tools with which to tackle them, according to Jennifer Johnston, Franklin Templeton Fixed Income’s Director of Research, Municipal Bonds. She provides her latest outlook.

In January, we discussed the start of US state budget season and what we were seeing from one large state, California. As May 2023 ends and state legislatures get to work on budgets, we want to provide an update on what we are seeing and what we believe it could mean for muni credit.

We wrote about California extensively in January. We highlighted the projected deficit and described how California’s revenue volatility comes largely from its dependence on high-income earners and how all states could see slower revenue growth and potential budget deficits if the US economy slows. California just released its mid-May budget update (called the “May Revision”), which tells a story of further revenue slowing and an increased budget deficit. This update doesn’t come as a surprise to us, nor are we worried at this point. In fact, many states and some large local governments have released similar news over the past few weeks, and we want to outline what we think this means for muni credit.

What are states saying

California reported that its deficit has grown by US$9.1 billion since January, and New Jersey recently announced it decreased its forecast for income tax revenue by US$2.3 billion as April payments came in lower than expected. Illinois reported that tax revenue in April was US$1.84 billion lower than it was a year earlier. And at a more local level, there are reports that New York City has seen a US$1.6 billion increase in its budget gap just since April. How worried are we?

First, let’s put this news in context. The post-pandemic recovery was quite good for state and local governments. In addition to significant federal COVID-19 aid, strong economic growth led to robust tax revenue growth, large budget surpluses and the building of reserve funds. Several states that had the lowest credit ratings prior to the pandemic are stronger today than they were pre-COVID-19.

Second, while the numbers seem staggering, we have been expecting this revenue decline—there have been concerns about some type of recession for months. States report monthly cash flows—and combined with economic data—have expected the robust revenue growth of the last few years to stabilize, slow and potentially retreat.

Finally, states and local governments have many tools to address these challenges, and we expect most states to use multiple tools rather than depend on just one. We expect to see a combination of conservative revenue estimates, spending cuts, small revenue increases and the use of reserves.

While the forecast looks cloudy, state and local governments have largely planned well for a rainy day, and we believe they should be able to address these challenges without ratings downgrades or serious changes in credit quality.


All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Because municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the portfolio’s value may decline. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value.


This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal.

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